Understanding the Volker Rule and its Problems

In response to the economic crisis, Paul Volker, former head of the Federal Reserve Bank, convinced Congress to consider safeguards against speculative investment activities by financial institutions. Legislators reacted by endorsing the Volker Rule  (a provision of the Dodd-Frank financial reform), which would prohibit financial institutions from using government-guaranteed funds, deposits or bailout money for proprietary trading. Given that “aggressive” trading had little to do with economic crisis, it is puzzling why Congress would have taken up this issue and banned such a profitable business for financial institutions.

As expected, financial institutions have fought with regulators as the Volker Rule has evolved over the past several years. There is great disagreement about how to ensure that financial institutions do not assume undue risk in their activities, and more basically, what makes a transaction too risky.

By way of background, banks and other companies regularly hedge risk. If a company has exposure to a certain contingency, it is generally possible to find another entity to assume the risk at a price. This may be possible because the counterparty has a mirror image risk to the first company, or the counterparty wants to assume the risk for its own account. Banks find counterparties for their clients and serve as a conduit, although, historically, banks sometimes retained the risk on their own balance sheet.

Every day, banks and other institutions work with clients to offset risk. An example would be an airline hedging against the cost of rising fuel prices. It is possible for the airline to lock in its price of fuel for an extended period thereby eliminating any possible impact of higher prices on its income statement. This is a legitimate business for banks and not in question. A problem arises when a bank assumes oil risk for an airline and then keeps the exposure, thereby gambling on the subsequent movement of oil prices, rather than passing off the risk to yet another counterparty. It is this activity that the Volker Rule addresses.

When the Volker Rule was introduced, many banks and investment banks closed down their proprietary trading operations. These groups of traders sought out investment opportunities including unhedged bets against broad economic indices, bets against the movement of commodities and accumulation of stock positions in public and private companies. Pure and not so simple, these investment activities were managed by very experienced traders whose job it was to increase the earnings for their institutions. It would be fair to say that these businesses took on high levels of risk using the firms’ capital. It is also fair to say that they were quite profitable and their prohibition has dramatically impacted the income statements of many financial companies.

The financial institutions that conducted “prop” trading did so with a great control. Every large institution has high-level executives overseeing the risks of the organization. Generally, prop risk received the greatest amount of oversight. The simplest example would be a limit on the aggregate unhedged exposure in the institution. If a trader wanted to buy a large position in oil because he believed it would increase in the short term, he would only be allowed to do so if the amount of risk was within his personal limit and the risk did not take the institution over any corporate limits. Of course, senior executives could increase these limits if they deemed it appropriate.

The concern is that an institution might invest in oil, the commodity might plummet in value and the institution would generate a huge loss that would threaten its financial viability. And then, the federal government would need to bail out the company using taxpayer money because a bankruptcy would drastically impact the domestic and/or global economy. Needless to say, this scenario is way out there, but it is possible if an institution makes a very large and risky bet or a rogue trader exceeds his authority.

In any case, most large institutions have effectively disbanded prop trading. Many of the traders have taken jobs with hedge funds, which are in the business of prop trading. So, what all the fuss?

The problems relate to the hedging activities of financial intermediaries. Is hedging a form of prop trading? The answer is that if hedging is uncovered, meaning that a long position is unaccompanied by a correlating short position, it is prop trading and restricted by the intent of the Volker Rule. If the long exposure is covered by an equal sale of the exposure, it is not. Pretty simple? Actually not.

If a bank has a huge exposure to real estate developers and it sells hedges on construction material, is this a hedge? Maybe, depending upon whether the long and short transactions will generally move to the same extent in opposite directions. If a bank has a large floating rate exposure and it buys an interest rate hedge, this clearly would be acceptable under the Volker Rule. As you can see, relating the sides of hedges may not be simple and people (the counterparties and the regulators) may disagree that they are permissible hedges under the Volker Rule.

So, the negotiation of the specifics of the Volker Rule is getting more and more complicated every day. This deals mainly with what constitutes a legitimate hedge. I suspect it will take a long time for all the issues to be vetted and to make the Volker Rule operational.